Magazine

Commentary: ...Yes, It Does

January 26, 2003

By Catherine Yang and Timothy J. Mullaney

First, let's clear something up. Contrary to popular opinion, AOL is not a dying whale washed up on a beach. Anything but. With 35 million subscribers, it dwarfs MSN, the No. 2 Internet access service, which has only 9 million subscribers. In 2002, AOL is expected to rake in $7.2 billion in subscription revenues, up 18%, in spite of the slumping economy. And while its cash-flow earnings are expected to drop from $2.3 billion in 2001 to $1.4 billion in 2003, its margins are bigger than those of Time Warner's music or film units. Also, it has by far a larger market share than any of its Time Warner brethren. AOL has a potentially brighter future than the rest of Time Warner. It just needs to be independent to get there.

That's the glitch. The bungled merger with Time Warner left AOL looking like a wasting business. But if it were liberated from the rancorous AOL Time Warner culture, this onetime Internet star could shine once again. The potential synergies between AOL and Time Warner's entertainment units never worked out, so AOL is better off being free to make deals with the industry's best--whether that's Sony, Electronic Arts, or Warner Bros. Without any expectations for slow and steady profit growth holding it back, AOL could take the risks necessary to leap into the next stage of the Internet era.

Of course, despite AOL's great assets and potential, it faces a heap of troubles. Its U.S. advertising and e-commerce revenues declined from a peak of $2.3 billion in 2001 to $1.2 billion last year, and they are expected to bottom out this year at $747 million, according to Thomas Weisel Partners LLC. Meanwhile, its growth in net new subscribers has bogged down from more than 1 million a quarter during the go-go days to 206,000 in last year's third quarter. The grave threat is that millions of subscribers will drop it as they switch to high-speed Internet access. For now, however, the losses are manageable and can be reversed. It's crunch time, but AOL has the wherewithal to heal itself. Here's what should be done:

It must become a leader in the move to broadband. Right now 4.1 million of its members get AOL via broadband connections. Most get AOL for as little as $14.95 on top of broadband access from other providers, which costs another $35 to $45 monthly. About 650,000 get AOL's broadband product bundled with Web access from Comcast, Time Warner Cable, and major phone operators at roughly $55 a month. Bundling is the fast way to round up subscribers, since buying that way is more convenient for them, so AOL has to line up new bundle deals with the other major cable companies--including Cox and Cablevision--even if it means swallowing its pride and giving them a bigger slice of the revenue stream.

It must also cut prices. The $23.90 monthly fee for regular dial-up service is a keeper. Subscribers aren't bothered by the price tag. But to round up broadband subscribers, AOL must reduce its fee for customers who bring their own broadband access--lowering it from $14.95 to $9.95 a month, matching archrival MSN.

To make customers want to stick with AOL even when they shift to broadband access, AOL must come up with compelling new content offerings. This shouldn't be the glitzy HBO-type stuff that AOL Time Warner has been pushing. It should be practical services. AOL could easily build an online dating service to rival Match.com, which makes 20% margins for USA Interactive Inc. One promising target for acquisition is Lending Tree Inc., the newly profitable leader in online lending, which has predicted 70% annual earnings growth through 2007.

Next, AOL's ad strategy is badly in need of a makeover. Up until now, it has relied too much on ineffective banner ads. It needs to improve its use of new forms of advertising, including jazzed up classifieds and payments from advertisers for placements in search results. Net portal Yahoo! Inc. has done this and watched its ad revenues rise 32% in the fourth quarter.

Finally, to keep the cash cow producing, AOL has to shore up its basic operations. That includes everything from improving customer service to offering better parental controls to making e-mail capable of more easily handling photos and videos.

It won't be easy to set AOL free. It's on the hook for $10 billion in debt. But the sooner AOL gets going on its own, the better. Yang covers AOL from Washington, and Mullaney covers e-commerce.